E-piphany

What a great world we live in, where all assets rally but in sequence rather than in parallel! Yesterday, it was stocks soaring while bonds were quiet. Today, it was bonds soaring while stocks drifted. As before, the source of the rally is a bit of a head-scratcher; and, as before, it doesn’t matter much once Friday’s data (or tomorrow’s ADP preview of that data, if it is significantly different from expectations) prints. Bonds perhaps had the excuse (not available to equities) of being a trifle oversold. And bond traders were no doubt heartened by a Beckner piece citing various Fed officials musing about potentially continuing the MBS purchase program beyond its scheduled lapse in March. But it tends to be dangerous to play for big bull moves in fixed income in the early part of the year…so I am wary.

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A brief opinion paper from the St. Louis Fed (in the “Economic Synopses” series, 2009, Number 47), entitled “The Case for ‘Inflation First’ Monetary Policy, was published in mid-December. It went largely unnoticed, as is appropriate in most cases since the author is not a policymaker per se but merely representing his opinion.

However, in the context of the current debate over monetary policy, it is always useful to get a glimpse of the arguments of one side or the other to try and evaluate how compelling they are. Although this paper (available here) is only a page and a half, and perhaps because it is only a page and a half, it is worth reading.

The author argues that there are several reasons that central banks might want to operate under a “hierarchical mandate,” in which price stability is to be achieved before economic stability is attempted.

The first of these is that (as asserted by the author on the basis of one paper and the ambiguity of theory on the subject) money supply changes do not affect the real growth rate of the economy in the long run. Let’s concede that we are not sure.

More importantly, he observes that often monetary policy that is intended to stabilize the economy can destabilize prices. It is of course well-known that, say, easing monetary policy might help growth while goosing inflation, since MV≡PQ. The lever that pushes up real output (Q) is an increase in the money supply, which also tends to increase P (the price level). That is, the division of the effect of an increase in the money supply on the price level and output level is indeterminate…they might even, in some circumstances, have opposite signs…but tend to be similar in practice. This is not a problem if there is a demand shock, in which both prices and output are pressured lower, but becomes a real dilemma when a supply shock pressures prices higher while output is pressured lower.

This is a well-known dilemma, of course, and this is an important reason that a “hierarchical mandate” might be useful: it states clearly which effect the Fed is supposed to combat. In the case of a supply shock, dampening the swings in prices will tend to enhance the swings in output. The author cites Bernanke saying there is a long-run tradeoff of volatility in prices for volatility in output based on this observation. Again, from the crude quantity theory it’s hard to argue otherwise, although this doesn’t argue for stabilizing one over the other.

But the final point the author makes is this: “…policymakers might prefer a hierarchical mandate because the more firmly anchored are inflation expectations, the more aggressively policymakers will be able to pursue economic stability.”

Why is it a matter of faith in policymaker circles that “well-anchored inflation expectations” will anchor inflation actually experienced? This would be true if inflation was mostly a behavioral phenomenon: shopkeepers raise prices because they think their customers are expecting it. But I am not aware of any evidence that that’s how it actually works. More likely is that retailers tend to employ some sort of “cost-plus” approach, where changes in the costs of their inputs are reflected to some degree (based on the elasticity of supply and demand, and other things) in the prices they charge their end customers. That’s exactly the opposite causality: price increases respond to previous price increases, and somewhere back there prices rose because auction goods were bid up because too much money chased too few goods. No expectations are required at all to get that inflation started.

This strikes me as a theory that seems to sound very plausible but is very difficult to support with actual data. So too, as a result, is the author’s conclusion: “…policymakers…should think of price stability and economic stability as complements – the best way to achieve the latter is to be firmly committed to the former.” That is exactly the opposite of his previous observation, that achieving price stability puts all the economic volatility into real growth, and that observation made some sense.

How about this: maybe policymakers should avoid doing much of anything in response to supply shocks, until they figure out how the heck this all works?